Topic 2: Macroeconomics GDP Unemployment Inflation 1

What are signs of a healthy economy? High output, high income Low unemployment Stability (output, prices, etc.) 2

Measures of output Gross Domestic Product (GDP): market value of all final goods & services produced within an economy in a given time period. Gross National Product (GNP): market value of all final goods & services produced by a nation’s citizens in a given time period. National Income (Y): total income earned in an economy in a given time period. Equivalent to GDP in equilibrium. Net Domestic Product (NDP): GDP minus depreciation 3

GDP and GNP 4 GDP GNP citizens outside nation citizens inside nation non- citizens inside nation GDP Only GDP & GNP GNP Only

What we care about, what we observe 5 Most policy makers are more concerned with National Income (Y) or NDP, rather than GDP GDP is easier to measure We will refer to any these items as “output”, and treat them as approximate equals

How do we use GDP numbers? Provides a means of comparing standards of living between countries and overtime 6

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Does the map imply that people in India and eastern China have a higher standard of living than people in Utah or most of Australia? What’s missing? Population Size / Population Density A better measure of well being is GDP Per Capita 9

GDP per capita A better measure since Adjusts for differences in population Otherwise a big country can have higher GDP than a small country even if the small country has a higher standard of living Which country has the highest GDP per capita? Which country has the lowest GDP per capita? LINK 10

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Comments on GDP GDP does not account for income inequality. Counties with high GDP might have high income inequality. That is, a few very rich people may pull up the GDP for an otherwise poor country. Can be difficult to measure accurately, especially in developing countries and countries that do not collect or release data. 12

Economic Growth 13 Economic Growth = Sustained rise in real GDP per capita Causes: Increased workforce participation Increase output per worker hour Better quality (education & skills) of the work force More capital Better capital (improved technology) Declining share in agriculture (can work year round)

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US economic growth US GDP per capita over time 15

Economic Recession Recession = Negative economic growth The US government defines a recession as a period of two or more consecutive quarters of negative growth (declines to real GDP) 16

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US economic growth US GDP per capita over time 18

GDP Changes During Recessions 19 UK: US:

Economic Growth 20 Representing economic growth on the PPF Macroeconomic policy is concerned with Increasing economic growth Limiting the duration and severity of recessions and periods of slow growth

Calculating GDP 21

Gross Domestic Product (GDP) GDP is the market value considering monetary value allows us to add apples to oranges of FINAL goods and services if we count the value of the car, we shouldn’t add to it the value of the steering wheel. produced IN an economy by citizens and non-citizens within the boarders of a county in a given time period. usually annually or quarterly 22

Guidelines for calculating GDP 1. It must go through the market place. Otherwise, ignore it. 2. Should involve the 3 factors of production that year. Ignore payments towards future production, or things produced last year. 3. Don’t include transfers in ownership without production, or pure paper money transfers. 4. Nothing illegal. 23

Would the following transactions be counted by this year’s US GDP? Hire neighbor teenager to babysit or cut your grass No–doesn’t go through the market place. Under-the-table payments. Buy a pizza from the local pizza joint owned by an Italian citizen Yes Do your own laundry when you would be willing to pay $10 for someone else to do it for you No—no transaction takes place Pay a laundry service to wash your dirty clothes Yes 24

Would the following transactions be counted by this year’s US GDP? Hire a limo driver to take you out for a night on a town Yes Hire a get-a-way driver for your weekend bank heist No—illegal transaction Buy a bottle of French wine from the local wine store Mostly No—the wine production would not count, but the value added by the wine shop and US importers would count Use a stock broker to buy 100 shares of Google stock Mostly No—buying stock does not involve production so it doesn’t count, but the services provided by the broker do count 25

Would the following transactions be counted by this year’s US GDP? Boeing builds a plane in Kansas which it sells to the US government Yes Grow weed to sell to one’s roommate No—illegal transaction & doesn’t go through market Go skiing at a Utah resort Yes Buy a 2007 Ford Mustang from someone on Craig’s List No—production didn’t take place this year 26

Would the following transactions be counted by this year’s US GDP? Firestone produces tires which it sells to Ford for use on new trucks Indirectly—The production contributes to GDP by adding to the value of the Ford trucks. But, they shouldn’t be double counted if we are already counting the trucks. Ford builds a Mustang this year that sits on a dealer’s lot before being sold next January Yes—All of the production (except some dealer services) took place this year. That’s what counts. Brazilian citizen attends UM as a student, paying tuition Yes—education is a service 27

Calculating GDP: big picture Expenditure approach Add together how much households, the government, and investors spend on all final goods and services, adjust for net exports (i.e., exports minus imports) Income approach Add together total compensation, interest payments, rental income, owner income, and profits in the economy 28

Calculating GDP The Income and Expenditure approaches are equivalent GDP = Y = C + I + G + (X – M) Y = Income, C = Consumption, I = Investment, G = Government Spending, X = Exports, M = Imports 29

Circular Flow Diagram 30

Expenditure Approach, example Numbers in billions for US, year 2008 C = $10,003 I = $2,056 G = $2,796 X-M = -$706 (i.e., trade deficit) GDP = Y = $14,151 31

Practical Tools for Calculating GDP Expenditure Approach: Count only final sales. (Works if all transactions happen in the same year.) Income Approach: Count value added (VA) for each stage of production. VA = final sales - intermediate goods GDP = Σ VA DON’T double count. Avoid counting Value Added and Final Sales. 32

GDP Example In an economy, there are three producers: a grape farm, a winery, and a liquor store. All production goes towards the production of wine. What’s their Value Added? Buys input atSells output atVA Vineyard0$75k Winery$75k$200k Liquor store$200k$300k 33

GDP Example In an economy, there are three producers: a grape farm, a winery, and a liquor store. All production goes towards the production of wine. Buys input atSells output atVA Vineyard0$75k Winery$75k$200k$225k Liquor store$200k$300k$100k Total:$300k 34

GDP Example GDP = Total VA = Value of Final Goods Buys input atSells output atVA Vineyard0$75k Winery$75k$200k$225k Liquor store$200k$300k$100k Total VA:$300k 35 Value of Final Goods Total Value Added

Liquor Store Value Added 36 The liquor store bought inputs for $200K, sold outputs for $300K, and added value of $100K. What did the liquor store produce? A retail service, which counts towards GDP just like production itself

GDP Example 37 The liquor store sells some of the wine during their annual closeout sale, and total sales fall to $250k… The vineyard is located in a different country… If the vineyard produced the grapes and sold them to the winery last year, but the winery and liquor store didn’t do anything themselves until this year…

GDP Example 2 Consider an isolated island economy with only three industries: fish, wool, and cloth. There are no other inputs or production that is not listed here. 1. Commercial fishermen catch boatloads of fish per year, all of which is bought by consumers for a total of $25, Sheep herders raise sheep which they use to produce wool, all of which is sold to cloth producers for a total price of $30, The cloth producers use the wool to produce 11,000 yards of cloth per year, which they sell to households for $100,000 total. (Households use the cloth to make their own clothing.) 38

GDP Example 2, continued a) Calculate value added by each industry: fish, wool, and cloth. b) What is the total value added in the economy? c) What are the final goods sold in the economy? What is the total value of final goods sold? d) What is the island’s GDP? e) What happens if the wool was produced the year before? f) What other changes would effect GDP? 39

Unemployment 40

Unemployment 41 When there is unemployment, the economy isn’t utilizing all of its factors of production: The economy is inside of its PPF. By decreasing unemployment, we increase output. By increasing output, we decrease unemployment. (Also, unemployment can decrease human capital, which can cause the PPF to shift in…)

Unemployment Rate Unemployment rate = 42 # of people unemployed Labor force

Unemployment 43 Who’s considered unemployed? : 1. Must be eligible for the labor force: 16 or older and not in jail, hospital, or some other institutional care 2. Must not have a job 3. Must meet one of the following descriptions 1. Without work but has made specific efforts to find a job within past 4 weeks 2. Waiting to be called back to a job from which he or she was laid off 3. Waiting to start a new job within 30 days

Dividing up the population 44 Total Population

Dividing up the population 45 Total Population Labor force eligible population

Dividing up the population 46 Total Population Labor force eligible Labor Force Eligible but don’t participate

Dividing up the population 47 Total Population Labor force eligible Labor force Unemployed Employed

Dividing up the population 48 Total Population Labor force eligible Labor force Unemployed Employed “Not in Labor Force”

3 types of unemployment Structural – comes from the rigidity of the labor market; minimum wages, lack of required skills; things that could be fixed through better policy, education, or training 2. Frictional – the natural flow of people between jobs or careers, or transition into the workforce 3. Cyclical – unemployment resulting from economic downturns Natural Rate of Unemployment = Structural + Frictional (Natural Rate exists even if a healthy economy)

Types of unemployment 50 A mother returns to work after raising her children? Frictional Graduate from college and must find a job? Frictional Unemployment caused by a minimum wage law? Structural Unemployment resulting from lack of information about available jobs? (i.e., bad matching) Structural

Types of unemployment 51 Real estate brokerage lays off some of its agents in a bad economy? Cyclical A steel plant lays off some of its works after the government eliminates steel tariffs Structural (skills don’t match the needs of employers) GM lays off workers due to poor economic conditions? Cyclical GM lays off workers due to changing production technology? Structural (skills don’t match the needs of employers)

Types of unemployment 52 A college student decides they want to work on the side while taking classes Frictional You move to NYC then start looking for a job? Frictional A 15 year old is looking for a summer job? Not counted as unemployed (younger than 16)

Types of unemployment 53 A laid off worker decides to return to school instead of searching for a job Not in labor force A laid off worker plays video games all day instead of looking for a job, since she doesn’t expect to find one in such a bad economy Not in labor force (“discouraged worker”) A worker at a pizza joint is searching for a job as an engineer Not counted as unemployed (she is “underemployed”)

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Labor Market Supply, determined by workers Demand, determined by employers At Equilibrium, everyone looking for a job is employed Unemployment is a surplus of workers in this model If there is unemployment, then the wage rate should fall to the equilibrium wage. (But, “sticky” wages might delay the adjustment to equilibrium.) 55

Labor market in a downturn 56 Demand for workers decreases Wages are slow to respond (“Sticky” wages) Why might wages be sticky? current employee happiness contracts (unions) bills – have expenses that must be paid This causes unemployment, until wages adjust, or economy recovers

Fighting unemployment If macroeconomic policy increases output (GDP), this will increase the demand for workers, thus reducing unemployment. 57

Inflation 58 Inflation = “An increase in the overall price level”

Inflation 59 If prices go up, wages will go up too. Why are we concerned with inflation? People on fixed income Incentives to save or invest Stability (how to set interest rates, etc.)

Types of Inflation Demand-Pull Inflation Caused by an increase in aggregate demand e.g., consumers start spending a higher portion of their income, or a jump in government spending Cost-Push Inflation Caused by an increase in costs e.g., changes in the price of factors of production; natural resources increase in price (supply-shock), wages increase annually which can push up the price (wage-price spiral) 60

Measuring Inflation 61 Consumer Price Index (CPI) CPI = A price index computed each month by the Bureau of Labor Statistics using a pre-defined “market basket” purchased monthly by the typical family.

How is the CPI market basket determined? The CPI market basket is developed from detailed expenditure information provided by families and individuals on what they actually bought. Data from the Consumer Expenditure Surveys includes interviews with about 7,000 families from around the country, and another 7,000 families keeping diaries listing everything they bought during 2-week periods. 62

What goods and services does the CPI market basket include? FOOD AND BEVERAGES (e.g., breakfast cereal, milk, coffee, chicken, wine, full service meals, snacks) HOUSING (e.g., rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture) APPAREL (e.g., men's shirts and sweaters, women's dresses, jewelry) TRANSPORTATION (e.g., new vehicles, airline fares, gasoline, motor vehicle insurance) MEDICAL CARE (e.g., prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital services) RECREATION (e.g., televisions, toys, pets and pet products, sports equipment, admissions); EDUCATION AND COMMUNICATION (e.g., college tuition, postage, telephone services, computer software and accessories); OTHER GOODS AND SERVICES (e.g., tobacco and smoking products, haircuts and other personal services, funeral expenses). 63

How is the CPI price data collected? Each month, BLS data collectors visit or call thousands of retail stores, service establishments, rental units, and doctors' offices, all over the United States, to obtain information on the prices of the thousands of items used to track and measure price changes in the CPI. These economic assistants record the prices of about 80,000 items each month, representing a scientifically selected sample of the prices paid by consumers for goods and services purchased. 64

Links Source for the previous three slides: Relative importance of different items in CPI: ftp://ftp.bls.gov/pub/special.requests/cpi/cpiri2010.txt ftp://ftp.bls.gov/pub/special.requests/cpi/cpiri2010.txt 65

Calculating Avg Inflation 66

Using the CPI Inflation = Percent Change in Prices = Percent Change in CPI 67

Using the CPI (Example 1) Base Year CPI is always normalized to equal 100. CPI in base year: 100 CPI in year two: Inflation between base year and year two = 68 (Year two CPI) – (Base year CPI) (Base year CPI)

Using the CPI (Example 1) Inflation between base year and year two = If year two CPI was 107.4? If year two CPI was 97.2? If year two CPI was 159.8? 69 (105.1) – (100) (100) = = 5.1%

Using the CPI (Example 2) CPI in year one: CPI in year two: Inflation between year one and year two = 70 (Year two CPI) – (Year one CPI) (Year one CPI)

Using the CPI (Example 2) Inflation between year one and year two = 71 (207.3) – (201.6) (207.3) = = 2.8%

Using the CPI (Example 3) CPI in year one: CPI in year two: Inflation between year one and year two = 72 (170.0) – (184.3) (184.3) = = -7.8%

CPI by city 73 CityMiamiDetroitNew YorkSan Francisco Inf Inf Avg Inf Avg Inf Avg Inf

CPI by city 74 CityMiamiDetroitNew YorkSan Francisco Inf %32.0%31.8%39.4% Inf %20.8%31.4%23.7% Avg Inf Avg Inf Avg Inf

Using the CPI (Example 4) CPI 0 = value in initial year CPI T = value T years later AvgInf = Average inflation between year 0 and year T Solving for AvgInf: 75 CPI 0 ( 1 + AvgInf ) T = CPI T AvgInf = ( CPI T / CPI 0 ) (1/T) - 1

Using the CPI (Example ) CPI in year one: CPI in 10 years later: Average Inflation = ( CPI T / CPI 0 ) (1/T) – 1 = ( 167.8/ 128.0) (1/10) – 1 = = 2.7% 76

CPI by city 77 CityMiamiDetroitNew YorkSan Francisco Inf %32.0%31.8%39.4% Inf %20.8%31.4%23.7% Avg Inf %2.8% 3.4% Avg Inf %1.9%2.8%2.1% Avg Inf %2.4%2.8%

How to calculate the CPI 1. Determine the “market basket” of goods 2. Calculate inflation from the base year for the market basket 3. Multiply by 100 (e.g., 4.6% inflation becomes 4.6) 4. Add to base year CPI which is always 100 (e.g., = 104.6) 78

Calculating CPI (Example 1) 79 GoodMarket Basket Quantity Price 1998Price 1999Expend Expend Gasoline100 gal$1.40/gal$1.60/gal Bread150 loaves$1.30/loaf$1.20/loaf Milk300 quarts$0.75/qrt$0.77/qrt Total:

Calculating CPI (Example 1) 80 GoodMarket Basket Quantity Price 1998Price 1999Expend Expend Gasoline100 gal$1.40/gal$1.60/gal$140$160 Bread150 loaves$1.30/loaf$1.20/loaf$195$180 Milk300 quarts$0.75/qrt$0.77/qrt$225$231 Total:$560$571 Inflation between 1998 and 1999 ?

Calculating Inflation 81 Price of market basket in 1998 = 560 Price of market basket in 1999 = 571 Inflation between 1998 and 1999? (Market Basket Price 1999) – (Market Basket Price 1998) (Market Basket Price 1998) (571) – (560) (560) = = 1.96%

Calculating CPI If 1998 is the base year and inflation is 1.96%, what is the CPI in 1999? =

Calculating CPI (Example 1) If a different year is the base year and 1998 has CPI 204.3, then what is the CPI in 1999? CPI in 1999 must be 1.96% higher than the CPI in CPI in 1999 = (CPI in 1998) x [1 + (1998 to 1999 inflation)] CPI in 1999 = (204.3) (1.0196) =

Calculating CPI (Example 2) Last year, a typical family spent $35 on sandwiches and $27 on soda. Prices were $5/sandwhich and $3/soda. What is the CPI market basket? 7 sandwiches and 9 sodas If last year was the base year, what is the base year CPI? 100 (it’s always 100 in the base year) 84

Calculating CPI (Example 2) Last year, a typical family spent $35 on sandwiches and $27 on soda. Prices were $5/sandwich and $3/soda. The market basket is therefore 7 sandwiches and 9 sodas. This year, prices are $7/sandwich and $5/soda. What was the market basket price last year? $35 + $27 = $62 What is the market basket price this year? $7 x 7 + $5 x 9 = $49 + $45 = $94 85

Calculating CPI (Example 2) Last year, a typical family spent $35 on sandwiches and $27 on soda. Prices were $5/sandwich and $3/soda. The market basket is therefore 7 sandwiches and 9 sodas. This year, prices are $7/sandwich and $5/soda. What was inflation this year? 86 (Market basket price this year) – (Market basket price last year) (Market basket price last year) ($94) – ($62) ($62) = = 51.6%

Calculating CPI (Example 2) In the base year, a typical family spent $35 on sandwiches and $27 on soda. Prices were $5/sandwich and $3/soda. The market basket is therefore 7 sandwiches and 9 sodas. This year, prices are $7/sandwich and $5/soda. What is the CPI this year?

One last example 88 Suppose that The CPI in 1980 equals 82.4 The CPI in 1990 equals Inflation between 1990 and 2000 was 31.8% Questions: What was inflation between 1980 and 1990? What is the CPI in 2000? What was inflation between 1980 and 2000?

One last example 89 Suppose that The CPI in 1980 equals 82.4 The CPI in 1990 equals Inflation between 1990 and 2000 was 31.8% What was inflation between 1980 and 1990? (130.7 – 82.4) / 82.4 = = 58.6%

One last example 90 Suppose that The CPI in 1980 equals 82.4 The CPI in 1990 equals Inflation between 1990 and 2000 was 31.8% What is the CPI in 2000? Must be 31.8% higher than 1990 CPI (130.7)( ) = (130.7)(1.318) = 172.3

One last example 91 Suppose that The CPI in 1980 equals 82.4 The CPI in 1990 equals Inflation between 1990 and 2000 was 31.8% What was inflation between 1980 and 2000? ( )/(82.4)= = 109.1% Why is this more than 58.6% %?